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Classifying Costs

Anonymous A asked on Oct 12, 2018

Is marketing a fixed or variable cost?

What about equipment? Can it be considered a fixed cost, or should it rather be considered a capital expenditure? Or is the maintainance of equipment fixed costs and investment in new equipment a capital expenditure? Can IT costs be considered the same way?

Can someone explain what admin costs comprises of?

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Elias
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replied on Oct 12, 2018
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Hi,

very often in these questions, people seem to confuse the nature of costs (fixed or variable) with the distinction between investment and costs (and cash out, which is a topic for another post).

So:

  1. Capital Expenditures are NOT costs. They are investments (=do not show up in the company's P&L, only in cash flow statement)
  2. Capex are translated into costs through Depreciation and Amortisation. So you invest 1 million into something this year, depreciate it over 10 years, so the resulting COST this year is 100k. (assuming you bought it on Jan 1st ;-) )
  3. Depreciation is (in a short-term view) always a FIXED cost. Once the investment is done, there are not many legal ways to change depreciation.

Marketing and maintenance costs are in their nature variable. It may not be a good idea to vary them, but they are variable. They do, however, not necessarily vary WITH OUTPUT. I'm saying not necessarily because there may be marketing costs (PPL or CPO ads for example, that may actually vary with output). But for most intents and purposes in a case, you can put marketing and maintenance into the fixed cost bucket which needs to be recovered through the raw margin of the product.

The raw margin of the product is the price of the product minus those costs that are directly affected by output (i.e. you produce 1 car, you incur the cost for 1 steering wheel, 2 tail lights, 4 tires. If you produce 2 cars, you need 2 steering wheels....) You get my point...

Hope this helps

Hi Elias, I have a question to your comment. If I understood you correctly, for a case dealing with an investment decision we would divide costs in Capex and Opex? (see Innogy Case) In terms of a profitability case we would analyze the cost structure in fixed and variable costs in oder to identify potential cost decrease measure or revenue growth potentials? — Lukas on Oct 12, 2018 (edited)

Hi Lukas, in a profitabilty case you might get away with ignoring capex and stopping at EBITDA. Once you want to get to EBIT you obviously need the values for depreciation. For an investment decision you definitely do need capex. But remember that an investment decision is in essence a multi-year profitabilty case. So the (discounted) profits (Cash Flows, to be more precise, so use EBITDA as a cash flow proxy) accumulated over the lifetime of the asset should exceed the investment. If not, it's a bad investment... — Elias on Oct 13, 2018

Vlad replied on Oct 12, 2018
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Hi,

The costs that you've mentioned are usually fixed. In real life it's different and a bit more complicated since you have the capex and amortization, but always remember that the case is a simplification.

It also may be considered as the part of the investments if you have an investment decision case. Usually, the interviewer will tell you upfront

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Guennael replied on Oct 12, 2018
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Marketing can be both a fixed or variable, depending on the exact cost and the company: for example, add purchases would typically be fixed, but a targeted price reduction to your retailer customer (which is a marketing spend in my company) would be variable.

The other costs you suggest are typically fixed. If you are unsure though, you can ask "is it fair to assume all the IT costs are fixed, or are some parts of it variable? How does the company account for them?"

Alessandro
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replied on Oct 12, 2018
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the definition of a variable cost is a cost that varies with output.

Marketing does not have a direct relationship with how many units you sell, so it should be treated as a fixed cost. Of course, more marketing might mean you sell more, but whether you sell 10 more units of your good, your marketing expenditure can increase. Of course, as Elias says, it's variable in the sense that you can change it (and isn't "set in stone" like depreciation) but this isn't really relevant to a case interview (e.g. how you would calculate break-even).

For the purpose of an interview and classifying costs as fixed or variable, you should ask yourself "If i sell 1 more unit of this good, will I incur this cost type as an additional cost?" If the answer is yes, it's a variable cost. If no, it's a fixed cost.

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